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The Ultimate Beginner's Guide To Deflation

Jul. 10, 2012 10:44 AM ETby: CommodityHQ

By Jared Cummans

Inflation is one of the most talked about phenomenons of the financial and economical world. Central banks have spent years trying to push and pull at inflation rates, much to the dismay of a number of analysts who feel that it should simply run its course. From hyperinflationary environments in Zimbabwe, where banks issued $50 million bills and billionaires could go hungry, to more tame examples like the U.S. in the 1970s (though this was still a pretty serious bout of inflation). Still, for all of the attention that inflation receives, its sister environment, deflation, gets the short end of the stick.

What is Deflation?

Because deflation has never really been a life-threatening issue to the U.S., many are unaware of exactly how it works and the impact it has on a surrounding economy. Simply put, deflation is when inflation rates fall below 0% and there is a general decline in prices. This should not be confused with disinflation. Disinflation is simply the decrease in inflation over time; once that decrease crosses below the 0% threshold, it becomes deflation. Declining prices means that the money you hold in your hand gets more and more valuable by the day, making cash hoarding a popular go-to, as sitting on a pile of money can literally pay dividends for you down the road. But this increase in value of currency causes a number of problems in an economic environment, and is sometimes regarded as far more serious than inflation.

Why Deflation is Bad

It may seem like an asinine subject to some, but digging into exactly why deflation is bad can be a very useful exercise for investors and analysts alike. When prices decline, as stated above, individuals are incentivized to save their money and spend little. That can create a shock in an economy as there is suddenly less capital flowing around and businesses begin to struggle. This also discourages borrowing as there is little point to taking out a loan since you would have to repay the loan with dollars that are worth more than the dollars that were borrowed. This puts a pinch on banks which creates a ripple effect on the surrounding economy.

Deflation also forces lower wages for employees, as businesses need to accommodate for the losses they are taking based on falling prices. All of these factors combine to create a downward spiral, which has the potential to propel deflation to a new level. As prices decline and wages fall, employment drops and consumers begin hoarding cash with the expectation of prices continuing to decrease. This hurts the economy, which in turn feeds into the saving habits that create something of a perpetual motion machine heading straight down. To put it in a concise statement:

Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals.

The best real world example of deflation comes from Japan, as the economy slipped into such an environment in the early 1990′s and has yet to recover. The central banks attempted to intervene with rate policies and the like, but those were abandoned in 2006 when it was determined that they were not having a significant impact on the recovery. In 1990, the Nikkei 225 Index was at 40,000. Since then, that benchmark has trended downwards, and currently sits around the 9,100 level, a decrease of approximately 77%; a devastating impact for investors and citizens alike. For an economy that was largely predicted to take over the U.S. as the biggest in the world, deflation meant the end of that dream for the foreseeable future.

As far as the U.S. is concerned, deflation hasn't really been an issue since the 1930′s, as we have been fortunate enough to avoid the phenomenon. But when it did strike, like in the early 19th century, agricultural commodities took a devastating blow that rattled the surrounding economy. We have entered what economists have called "minor" deflationary periods as recently as 2009, but inflation kicked back up shortly after, saving us from a potentially deeper recession. Many experts and analysts have speculated what the long-term impacts will be from all of the recent money printing and interest rate manipulation by the Fed. While in the short-term it will likely cause inflation, its lasting effects could work in the opposite direction down the road, though the likelihood of this happening is relatively low.

How Deflation Impacts Commodities

Understanding and watching for deflation is obviously essential to all facets of investing but it is especially important for commodities. During deflation, a number of commodities will dip in price, leading to an erosion in value for many investors and a devastation of some of their positions. While savvy traders can always find ways to profit, the general health of the commodity world would be in shambles. In a world like that, put options are going to be your best bet, as they will profit as major commodities continue to sink. There are also a fair amount of bloggers and analysts that argue that gold will perform well during deflation, though there is heavy debate around that subject.

All in all, deflation should be one of the most serious words in a commodity investor's vocabulary and is something to always keep an eye on. While its presence may seem removed from our economy, the possibility always remains and preparation will be key to survive a deflationary environment.

Disclosure: No positions at time of writing.

Disclaimer: Commodity HQ is not an investment advisor, and any content published by Commodity HQ does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities or investment assets.

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